Cash & Liquidity ManagementInvestment & FundingDerivatives dilemma amid Brexit uncertainty

Derivatives dilemma amid Brexit uncertainty

As the Brexit negotiations go down to the wire, the City’s lucrative $2bn-a-day derivatives trade remains in jeopardy because of a stalemate over market access

In the final week before Christmas, disruption in the trade was looking likely because neither party could agree on the all-important recognition of each other’s derivatives trading venues under an equivalence regime.

The stand-off threatens to inflict damage to the City’s global dominance in over-the-counter interest-rate derivatives activity. At the end of 2019, Britain’s share of the OTC interest-rate market was 50 percent, up from 39 percent in 2016.

Failing an agreement on equivalence, the International Swaps and Derivatives Association (Isda) predicts “significant issues for counterparties subject to the derivatives trading obligation (DTO) and other requirements under derivatives legislation” on both sides of the Channel.

The consequences include most notably the further fragmentation of liquidity in the over-the-counter derivatives markets. The worst-affected instruments would be those in the most liquid interest-rate swap markets – that is, in euros, dollars and sterling – as well as index credit default swaps, warns the ISDA.

Generally, the Isda expects “a significant increase in operational complexity and unpredictable implications for effective market functioning.” Although both parties could take certain technical steps to mitigate the impact of the conflict between their respective DTOs, they would be unlikely to fix the issue. The least disruptive solution, argues ISDA, would be a simple recognition that EU or UK trading venues were equivalent.

But that doesn’t look likely. These negotiations are being conducted separately from the inter-governmental ones over trade and other matters. The fundamental issue is that Brussels insists that banks in the bloc must trade these derivatives from its side of the Channel from January while the Bank of England has said that UK-regulated banks must continue to use derivatives platforms in London.

In a late November statement the European Securities and Markets Authority (Esma) appeared to say that a decision over equivalence was not absolutely vital and blamed Britain for the uncertainty. “[The] situation is primarily a consequence of the way in which the UK has chosen to implement the DTO,” it said.

The authority has also played down the probability of disruption. “There is no evidence that in the case of a no-deal Brexit and in the absence of an equivalent decision by the European Commission covering UK trading venues, market participants will not be able to continue meeting their obligations under the DTO,” Esma said, citing the new trading venues established in the EU by most UK venues that are offering what are known as in-scope derivatives trading.

However the authority acknowledged the “challenging situation” for  UK-based branches of EU investment firms because they would probably be subject to dual DTO obligations. It did not though plan to introduce any measures that would make compliance easier for these firms. Rather, they would have to adapt “their current business practices to ensure compliance with EU law.”

To date, levels of trading on these new venues are low, but Esma remains optimistic. The authority expects that the arrival of what it called “major liquidity providers” would allow EU investment firms to comply with the DTO when Britain finally departs the bloc.

Bank of England governor Andrew Bailey has said it has done its best to reduce the risk of disruption and would be standing by to mitigate the impact of a complete impasse over the issue. Deputy governor for financial stability Jon Cunliffe said last week that it was impossible to know which companies were prepared for the transition until the deadline passed.

On the bright side, the UK and US have already agreed on measures that will assure the continuity of derivatives trading and clearing between the two countries. “They provide a bridge over Brexit through a durable regulatory framework upon which the thriving derivatives market between the UK and US may continue and endure,” said Christopher Giancarlo, chairman of the Commodities Futures Trading Commission, at the time the agreement was signed in February 2019.

The agreement is based on “no-action” letters that will allow the instruments to trade without interruption.

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